High-quality short dated investment grade credit is increasingly being favoured by investors of all types - from individuals to investment professionals across wealth manager groups and pension schemes - for a variety of reasons.
Firstly, interest rate volatility has picked-up meaningfully as sticky inflation has caused central banks to tighten monetary policy more than what markets anticipated, pushing yields higher. Secondly, while cash rates have become more attractive, for a little more risk, short dated investment grade credit can offer a yield pick-up over cash and government bonds, helping investors to increasingly sweat the cash element of their portfolio. Finally, the inversion of the yield curve has meant that yields on shorter-dated bonds are now higher than yields on longer-dated bonds, offering more yield for less duration risk.
Passives represent a greater market share
When choosing short dated corporate bond funds, UK investors often look to passive vehicles, citing the lower return potential of the broader asset class. Roughly a quarter of the all-maturity sterling corporate bond market is passive (£12bn out of £48bn) compared to almost half of the short dated market (£4.3bn out of £10bn). This may seem intuitive, as investors perceive there to be little absolute return or potential excess return on offer in relatively low risk short dated corporate bonds. Therefore, why pay up for active management?
IA £ Corporate Bond sector, short dated versus all-maturity
Source: Fidelity International, Morningstar, 30 June 2023. Data taken from funds in the IA Sterling Corporate Bond sector.
Passive is suboptimal in short dated corporate bonds
Despite this backdrop, we strongly believe that going passive in the short dated space is sub optimal. This goes beyond the typical arguments for going active over passive, which include, for example, picking the winners and avoiding the losers (this certainly also applies here).
As a general rule, passive funds underperform their indices on a net basis because of fees and transaction costs. We'd argue that this underperformance is more pronounced in the short dated space because the absolute level of return is more muted than in other parts of the maturity spectrum. Indeed, while some investors look to go passive in the space because the return potential is lower, paradoxically, for that same reason, it may make sense to consider going active.
To illustrate this, we've looked more closely at all three passive short dated funds in the IA £ Corporate Bond sector, with the longest running track record going back to 2014. Since inception, this passive fund has delivered an average calendar year underperformance of 0.2% versus its respective index. Considering the average calendar year return from the index was 1.1% over the period (2014 to 2022), a 0.2% underperformance is almost 20% of total return lost.
We would argue that 0.2% in return in the short dated space means more than 0.2% return in higher risk asset classes, such as equities or all-maturity bonds.
What's more, most passive short dated funds tend to underperform their indices by more than the fees charged which we believe is due to the additional costs arising from elevated trading, associated with trying to replicate a short dated index.
In this regard, it is important to note that a 1-5 year index constantly has bonds entering the index as they move from six years to five years in maturity, as well as bonds falling out of the index as they move below one year in maturity. This will lead to elevated trading for the passive community aiming to replicate this exposure, as they may be forced to buy and sell respectively at either end of the maturity spectrum. To illustrate this maturity migration, we estimate that 41% of the 1-5 year index (in terms of number of bonds) we use for Fidelity Short Dated Corporate Bond will move in and out of the index over the next 12 months alone! And this excludes the impact from potential new issues.
This excessive and forced trading does not occur for all-maturity passive bond funds. It is notable that short dated passive funds can underperform their indices more (after fees) than their all-maturity counterparts, despite being offered by the same provider and therefore presumably using the same trading processes.
Exploiting the passive community
As active investors, we are happy to take out-of-index exposure across sub-one year bonds and up to six year maturity bonds. For example, we can buy a sterling investment grade bond with five and a half-years left to mature, knowing this is about to enter the 1-5 year index and therefore benefit from forced passive buying. At the other end of the maturity spectrum, we can buy bonds with sub-one year maturity to take advantage of forced passive selling. This paper has additional benefits and can prove to be an attractive hunting ground for active investors, despite being so close to maturity.
As at the end of July 2023, 7% of the Fidelity Short Dated Corporate Bond Fund (all off-benchmark) matured in less than one year. Somewhat remarkably, the average yield to maturity on this sub-one year paper (6.14%) is greater than the yield on the index (6.10%), despite the lower interest rate risk associated with it. Part of this yield advantage is due to forced selling by passives due to their rules-based, rather than value-based, approach. Sub-one year paper also acts as natural liquidity as the bonds generate cash for the portfolio as they mature. This has further benefits in a rising yield environment as we can then deploy the cash into higher yielding securities. Investors who use the fund as a cash diversifier often like this liquidity feature.
Time to consider an active fund?
The Fidelity Short Dated Corporate Bond Fund is primarily invested in high quality short dated corporate bonds and was launched back in 2016, employing a highly active approach. The Fund is managed within Fidelity's highly experienced sterling investment grade portfolio management function, alongside our flagship Fidelity Sustainable MoneyBuilder Income Fund.
The Fund has generated attractive excess returns over index (after fees) since inception and is one of Fidelity's lowest volatility bond funds. Plus, relative to the IA Sterling Corporate Bond Sector, the Fund is currently first quartile over one, three and five years, offers a first quartile yield, a first quartile risk profile (in terms of five year volatility) and first quartile fees, with ongoing charges of just 0.24%.
Fidelity Short Dated Corporate Bond Fund performance overview
Past performance is not a guide to the future.
Source: Fidelity International, Morningstar, 31 July 2023. Performance reflects Fidelity Short Dated Corporate Bond Fund W Income Shares, basis Bid-Bid with income reinvested in GBP. Comparative Index: ICE BofA 1-5 Year Eurosterling Index. Quartile stats based on Morningstar data in the IA Sterling Corporate Bond sector to 31 July 2023. Index stats based on the ICE BofA Euro Sterling index relative to the ICE BofA 1-5yr Eurosterling index, using data from August 2023. The ongoing charges figure is for the year ending 28 February 2023. This figure can vary from year to year.
Calendar year return tables
|
|
2018 |
2019 |
2020 |
2021 |
2022 |
|
Fidelity Short Dated Corporate Bond Fund |
-0.1% |
4.4% |
2.9% |
0.5% |
-6.6% |
|
ICE BofA 1-5yr Eurosterling Index |
0.0% |
3.9% |
3.1% |
-1.0% |
-7.3% |
|
Legal & General Short Dated Sterling Corporate Bond Index Fund |
-0.3% |
4.9% |
3.9% |
-1.0% |
-7.7% |
|
Markit iBoxx GBP Corporates 1-5 Index |
-0.3% |
5.0% |
3.8% |
-0.7% |
-8.1% |
|
Vanguard U.K. Short-Term Investment Grade Bond Index Fund |
-0.2% |
3.7% |
3.0% |
-1.2% |
-7.4% |
|
Bloomberg GBP Non-Government 1-5 Year 200MM Float Adjusted Bond Index |
0.0% |
3.8% |
3.2% |
-1.0% |
-7.3% |
|
ASI Short Dated Sterling Corporate Bond Tracker Fund |
- |
- |
3.2% |
-1.4% |
-7.2% |
|
Markit iBoxx Sterling Non-Gilts (1-5 Year) |
- |
- |
3.1% |
-1.0% |
-7.3% |
Source: Fidelity International, competitor websites, 31 July 2023. All data is net of fees.
This post is funded by Fidelity International
Important Information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. The value of bonds is influenced by movements in interest rates and bond yields. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the Fund investing in them. Fidelity's fixed income range of funds can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. . Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document (Key Information Document for Investment Trusts), current annual and semi-annual reports free of charge on request by calling 0800 368 1732. Fidelity only gives information on products and services and does not give investment advice to retail clients based on individual circumstances. Issued by Financial Administration Services Limited and FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0823/381792/SSO/NA
